Breitburn Energy Partners L.P. (NASDAQOTH:BBEPQ) uses oil and gas hedges to protect it from commodity price volatility. These hedges have historically enabled the company to mitigate commodity price volatility for several quarters, giving it time to make adjustments. But that time has proven to be a two-edged sword as it has also given the company the confidence to be more aggressive on borrowing money to fund growth. It's a decision that backfired as Breitburn's debt load has been a nearly unbearable weight on the company's unit price, which is down more than 80% over the past year.
Steady as she goes
Breitburn Energy Partners has about three quarters of its production hedged in 2015, about two-thirds hedged in 2016, and about a third hedged in 2017. These hedges not only provide a floor for its cash flow, but really help to stabilize its cash flow in the short term as we can see on the following slide.
What's noteworthy about that chart is when oil prices plunged by more than 50% in 2008, Breitburn's cash flow only went down 24% from peak to trough. Meanwhile, the more recent plunge in oil prices has yet to impact the company's cash flow as its oil hedges, combined with an acquisition, actually pushed cash flow higher in the first quarter.
A little too overconfident
Due to the stability of its cash flow, Breitburn seemed to get a bit overconfident as it borrowed an incredible amount of money over the past few years to fund growth, which we can see on the chart below.
It did so knowing that the cash flow needed to support that debt was largely secured via hedging. That said, one of the main sources of debt that Breitburn used was the borrowing capacity on its credit facility, which is a short-term funding mechanism. The benefit of using the credit facility was the fact that it carried a very low interest rate. Because of that, at the time oil prices crashed last year Breitburn had borrowed nearly $2.2 billion of its $2.5 billion borrowing capacity, or 88% of its available credit. It had originally intended to borrow the money short term and then go to the capital markets for longer-term funding when it saw an opportunity for great terms, but those terms never materialized before oil prices came crashing down.
This became a real problem for the company as its credit facility came with a lot of strings attached. Breitburn noted this in its annual report by writing, "Our credit facility has substantial restrictions and financial covenants that may restrict our business and financing activities and our ability to pay distributions."
More importantly, it noted, "Our credit facility limits the amounts we can borrow to a borrowing base amount determined by the lenders at their sole discretion based on their valuation of our proved reserves and their internal criteria." In other words the company's credit line could be cut by its banks at their sole discretion based not on the company's cash flow but on the value of its reserves.
The problem here is that its hedges don't protect the value of its reserves, meaning a steep drop in oil prices would likely impact reserves before cash flow. That put the company in a tight spot earlier this year as it was at risk of having its borrowing capacity cut by its banks, which was a problem as Breitburn had already borrowed all but 12% of its capacity. If its banks cut its borrowing base below its outstanding borrowings, Breitburn would have to come up with enough cash to pay the difference.
Breitburn Energy Partners' robust hedge book mitigated a lot of the volatility on its cash flow. Because of that it gave the company confidence to borrow to fund its growth. But in hindsight the company was a bit overconfident as it borrowed almost up to its limit. The problem with this is the credit facility wasn't backed by cash flow but instead on the value of its reserves, which would drop much quicker when oil prices reset. Clearly, the company was much more aggressive than it should have been and that really came back to bite the company when oil prices crashed.